Larry's VC View is the bi-weekly blog by photonics entrepreneur and budding venture capitalist Dr. Larry Marshall who shares his thoughts and reflections on the VC scene, as he makes the transition from serial entrepreneur and engineer, to Venture Capitalist. He hopes to share his experiences, lessons and mistakes with fellow entrepreneurs seeking venture funding.

Thursday, May 19, 2011

A number of investors gain confidence and comfort from entrepreneurs who have invested their own money in their startup. So much so, that many entrepreneurs find unusual ways of claiming their investment--in some cases you hear of millions of dollars personally invested in a deal, where the cap table does not reflect that cash because it was in kind, or missed opportunity value, or perhaps just unpaid salary. Interestingly many more investors don’t like entrepreneurs to have their personal net worth at risk in a deal. I know many Sydney fund managers who would be laughing at this ignorance of clear alignment: it’s an example of how opposite Silicon Valley is to other places.

The problem is actually a simple one: when a venture capitalist makes an investment, they want to ensure the team is highly motivated by their equity to succeed, and that their reward is mainly in the return on value of this equity. When a founder has substantial personal cash at risk, they will make poor decisions regarding risk--it's human nature to try to save your money rather that put it at (venture) risk. Look at how most entrepreneurs invest their own money and you will be surprised just how conservative they are, simply because their day jobs are so risky.

If an entrepreneur starts playing conservatively with VC money, they are likely to deliver a pedestrian return but VCs want an all or nothing play, it’s how their portfolio management works. A company that makes cash flow breakeven but does not provide a stellar growth opportunity is almost as much a failure as a company that craters--it’s the chance of the big win that justifies the VC level investment.

In fact, we can go step further, I know many successful fund managers in China who over the past 10 years made a lot of money simply by buying up established companies from the state, and introducing western IT practices and other efficiencies, then took them public in Shanghai for venture scale returns. However, after nearly 10 years of this working well for a small number of fund managers, larger PE firms stepped in to make it scale.

At that point, the model changed, and the PE guys started buying out the founders in order to get into the deal. The guys who pioneered this model in China would simply not invest in a startup if the founders were taking cash out of the deal. However, this is a very common practice in later stage investments here in the Valley--when a fund has a lot of cash to put to work, they often have to get creative as to how they deploy it and get more into a deal by buying founders stock.

I personally don’t like this approach because investors and entrepreneurs should be exactly in the same boat with interests aligned--and I like founders to win big whey they win and stay focused on maximizing value of their equity, not taking cash off the table. But sometimes, the only way to get into a really good deal is to buy your way in--works well for later stage investors, but not so well for VC. Personally, I don’t want to be in a deal that’s driven by price, in any dimension ...

To close on the story in China, those PE guys who bought into deals learned after about three years why the pioneers weren’t playing that game--it wasn’t that they were old fashioned or slow (let’s face it they jumped on a plane and immersed themselves in emerging China 10 years before it was popular, so hardly risk averse). The Chinese are some of the greatest capitalists on earth, and are quick to change--once bought out and handing over their hard build companies to the bankers, they quietly went across the street (in many cases literally) and started competing companies that rapidly secured deals with large state owned enterprises, and attracted the best employees who had recently learned western style efficiencies and could improve the new business, and rather quickly generated nice IPO exits on the Shanghai exchange ;-)

P.S. Patrick thanks for the great and thoughtful comment. It merits its own blog, and I'm working on that now.